By Jamie McGeever
BRASILIA (Reuters) - Standing beside U.S. President Donald Trump on a crisp afternoon outside the White House in Washington this week, a smiling Brazilian President Jair Bolsonaro enjoyed a moment in the sun.
Less than three months since taking office and with the Brazilian stock market at a record above 100,000 points, the former army captain was cementing his place on the world stage. He is following his U.S. trip with visits to Chile and Israel.
Back home, however, a political, economic and market storm was brewing that would turn the week into one of the most foreboding for his young administration, which has been slow to confront the mounting challenges to his ambitious reform agenda.
Brazilian financial markets reeled at the arrest of former president Michel Temer on corruption charges on Thursday and the unveiling on Wednesday of cuts in the military budget that were much more modest than expected. An opinion poll also showed plunging support for Bolsonaro's government.
Even before the latest developments, investors were uneasy about a global slowdown and a string of Brazilian economic indicators showing the tepid recovery from a 2015-16 recession is losing steam. The central bank took a dovish turn this week and the government cut its 2019 growth forecasts.
The Bovespa stock index shed 5 percent this week, its biggest weekly loss since August. On Friday, the 10-year bond yield jumped more than 25 basis points and the real slumped 2.5 percent, both their biggest moves since November.
(GRAPHIC: Bovespa index - weekly change - https://tmsnrt.rs/2OhZkVD)
(GRAPHIC: Brazil's 10-year bond yield - daily change - https://tmsnrt.rs/2UOvw5p)
(GRAPHIC: Brazilian real - https://tmsnrt.rs/2UR8sTk)
Investors are more focused than ever on Bolsonaro's signature proposal to overhaul the pension system in hopes of shoring up public finances, boosting growth and generating over 1 trillion reais ($257 billion) of savings over the next decade.
"The next three to four months are crucial for the country," XP Investimentos credit analysts wrote in a note to clients on Friday, adding they remained optimistic that "transformational" reform will be passed.
"However, we anticipate volatility, with tough negotiations ahead for pension reform and a series of risks that may increase tensions, like we saw this week," they said.
ALL EYES ON PENSIONS
Economists, traders, analysts, politicians and central bankers agree Brazil's economic fate lies largely with pension reform, and progress on that front appears to be slowing.
The Temer scandal has the potential to damage the pension reform drive. A close Temer confidant, who was also arrested, is married to the mother-in-law of Rodrigo Maia, speaker of the lower house of Congress and chief architect of the coalition to pass pension reform.
Investors were also underwhelmed by a government proposal on military pensions that would save around a tenth of what was promised last month due to salary hikes. That raised the prospect of other groups hardening demands in negotiations.
"This could create challenges for the administration in Congress as they were arguing this is a reform that fights privileges from public servants," wrote Morgan Stanley economists.
Bolsonaro's eroding support will also make it harder for him to close the deal on pension reform. An Ibope poll this week showed his government's popularity plummeted to the worst approval rating at this early stage of any administration since Brazil returned to democracy three decades ago.
All of that has investors and policymakers putting off hopes for a more robust economic recovery.
In keeping interest rates at a record low of 6.50 percent this week, the central bank highlighted the economy's weak performance and downgraded the inflation threat level.
On Friday, the Economy Ministry also cut their 2019 forecasts for growth, inflation, average interest rates and the real's average exchange rate.
($1 = 3.8897 reais)
(Reporting by Jamie McGeever; Editing by David Gregorio)